Terminating a financial contract

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Commerce gives the lie to the idea that life is a zero-sum game. This was Adam Smith’s great insight: things need not be nasty, brutish and short and, when it comes to commerce, generally aren’t.

Each of us will only strike a bargain if we think, on our own terms, we’ll be better off as a result. That being so, once we’ve built a good business relationship, there is no good reason to end it. All being well, trade is an infinite game. If we are good enough at it, we can keep its positive feedback loop going, for the mutual betterment of everyone, indefinitely. Infinitely, even.

Therefore, we wish our relationships well and pray Godspeed for their long and fruity lives. Should the plums dangling from this or that branch shrivel; if things become more trouble than they’re worth, we can of course call time and bid our relationship a peaceful transition to the hereafter.

But still, things do not always work out quite so equably. Sometimes, an ill wind blows. Relationships become fraught, counterparties get themselves in a pickle.

Therefore, we pack our trunk with tools, implements and weapons with which, if we must, we can engineer a faster exit from our contracts.

There are a few different ways this can happen. While lawyers will happily rabbit on about these hypotheticals in the gruesome specific, we do not talk about them in general terms often enough. So let’s do that now.

Below, we count the types of ways to safely put a commercial relationship in the ground.

Customers and service providers

Now the great majority of financial contracts are between a “provider” on one side — a bank, broker or dealer providing a “service”, broadly described: money outright, finance against an asset or a financial exposure — and a “customer” on the other who pays for that service. The customer is, as ever, king: the service exists for her exclusive benefit: the provider’s only wish is to manage its resources to most efficiently provide that service and extract a fee, commission or economic rent by way of consideration for it.

“Providers” are indifferent to how the instruments they serve perform. They do not mean to be “the other side” of the trade. They are, loosely, intermediaries. Agents. They match risk-takers, collect a fee and wish the parties well without taking sides: they are “compassionate”, not “empathetic”. As long as their customers remain in fine fettle, they should never need, much less want, to terminate their services, for that is how they earn a crust.

But all the same we should note something important here: the expectations of parties to a service contract are very different: the customer takes risk and retains the prerogative to go off risk as she sees fit, as long as she pays the provider’s fees and whatever it needs to terminate the arrangements it made to provide the service in the first place: its “breakage costs”.

But all else being equal, a provider cannot exit a service contract early without the customer’s permission. A fixed term financial contract, binds a provider in a way it does not bind its customer.

As long as the customer remains in good health, no problem. But the customer’s general prospects may darken. She may turn out not to be as good as her word. The regulatory environment may change, making the services harder or more costly to provide. There are times where a service provider may, justifiably, want out.

Where it is no longer sure of its expected return, the provider must have a set of “weapons” it can use to get out of its contracts. These fall into a bunch of different categories, as we shall see.

Put these “termination scenarios” into three categories: without cause; external events and counterparty failure.

Without cause

Terminations “without cause” arise just because — no fault, no pressing need; just a gradual drifting apart of interests. As we grow in life, the things we value change. Passions of youth dampen, we tend more towards scabrous songs of experience than exuberant songs of innocence. If this should mean our commercial paths diverge, we prescribe a notice period long enough to allow each other to make reasonable alternative arrangements, but otherwise, we wish each other well and carry on our way.

“Without cause” termination rights for a service provider will generally be “clean-up” arrangements: to clear out low-value and dormant clientry whose mere presence on the books implies ongoing compliance or operational costs. These rights will not usually impair in-flight Transactions, which a service provider must still see through before it can be allowed to move on.

Pseudo-termination rights

Dealers sometimes must have rights to terminate in-flight customer Transactions on notice without reason. These will often be “pseudo” rights that a dealer must have but will never actually use. These rights help to optimise their liquidity and capital buffers, therefore reducing the dealers’ own costs of doing customer business. For example, a swap dealer’s right to terminate a customer’s synthetic equity swap position on (longish) notice. If it has such a right, the dealer can treat its equity swap exposures as a “short-term obligation” for capital purposes — because it could get out, if it wanted to — and this is enough to get optimised regulatory treatment.

But a sound-minded dealer having such a termination right is a different and distant thing from ever exercising it. It might be forced to, in the direst of stress circumstances, where its own survival was threatened — we are in September 2008 territory here — but in that case, with the dealer teetering, most vigilant customers would be moving valuable positions away in any case.

Pseudo-termination rights, in that dealers absolutely must have them but would never use them, are a marker of incipient failure in the battle between substance and form. What matters is that the termination right exists, not that it is ever used. It is sometimes hard to persuade neurotic buy side types that such termination rights are harmless, but in large part they are.

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See also

• Adam Smith and Thomas Hobbes
• Events of Default
• Lending versus financing